Financing a New Warehouse While Retaining Family Control
Brahmaputra Cargo is a family-owned logistics firm in Guwahati. Its existing capital is equity share capital of ₹1.20 crore, retained earnings of ₹0.30 crore, and a term loan of ₹0.80 crore at 11% interest. The firm pays tax at 25%, and existing shareholders require 17%. It needs ₹1 crore for a new warehouse expected to generate EBIT of ₹25 lakh a year. Three plans are proposed. Plan A: issue fresh equity of ₹1 crore to a private investor. Plan B: borrow ₹1 crore at 13%, subject to a bank covenant limiting further debt. Plan C: use ₹40 lakh of internal accruals and borrow ₹60 lakh at 13%. The finance head estimates the overall cost of equity at 17.4% under Plan A, 19% under Plan B, and 18% under Plan C. The family holds 70% of the equity and wants to retain control. The banker wants the weighted average cost of capital under each plan and a check of interest coverage. Advise the family.
1. Compute the current WACC and the WACC under each of the three plans. State your assumptions.
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Current WACC: equity = ₹1.50 crore (share capital ₹1.20 + retained earnings ₹0.30); debt = ₹0.80 crore. After-tax cost of existing debt = 11%×(1−0.25) = 8.25%. WACC = (1.50/2.30)×17% + (0.80/2.30)×8.25% = 11.09% + 2.87% = 13.96%.
Plan A: total capital ₹3.30 crore; equity ₹2.50 crore, debt ₹0.80 crore; cost of equity 17.4%. WACC = (2.50/3.30)×17.4% + (0.80/3.30)×8.25% = 13.18% + 2.00% = 15.18%.
Plan B: equity ₹1.50 crore, debt ₹1.80 crore. Pre-tax debt cost = (0.80×11% + 1.00×13%)/1.80 = 12.11%; after tax = 9.08%. WACC = (1.50/3.30)×19% + (1.80/3.30)×9.08% = 8.64% + 4.95% = 13.59%.
Plan C: equity ₹1.90 crore (including ₹0.40 crore internal accruals), debt ₹1.40 crore. Pre-tax debt cost = (0.80×11% + 0.60×13%)/1.40 = 11.86%; after tax = 8.89%. WACC = (1.90/3.30)×18% + (1.40/3.30)×8.89% = 10.36% + 3.77% = 14.14%.
Assumption: the project's business risk is similar to the existing business; the costs of equity are the finance head's estimates, reflecting financial risk.
2. Compute interest coverage under each plan and interpret the results.
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Interest: Plan A = ₹0.80 crore × 11% = ₹8.8 lakh; coverage = ₹25 lakh/₹8.8 lakh = 2.84×. Plan B = ₹8.8 lakh + ₹13 lakh = ₹21.8 lakh; coverage = 1.15×. Plan C = ₹8.8 lakh + ₹7.8 lakh = ₹16.6 lakh; coverage = 1.51×.
A coverage ratio of 1.15× leaves almost no room for a fall in EBIT: a 13% decline would make EBIT insufficient to cover interest. Plan C's 1.51× is still thin but more defensible; Plan A is safest. Note that WACC alone favours Plan B, but WACC ignores the probability of financial distress and the covenant's restriction on future flexibility.
3. Recommend a financing plan, considering cost, control, and risk.
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Recommendation: Plan C, with conditions. It has a WACC of 14.14%, only 0.55 percentage points above Plan B, but interest coverage is 1.51× rather than 1.15×. It uses internal accruals and avoids the dilution of Plan A.
Control: the family holds 70% of ₹1.20 crore = ₹84 lakh of shares. Plan A's ₹1 crore equity issue, unless at a large premium, would take the family below 50%; even at a premium, control is weakened. Plan B preserves control but the covenant and 1.15× coverage are dangerous for a cyclical logistics business.
Conditions for Plan C: keep at least ₹25 lakh of undrawn overdraft, fix the new debt at a floating-to-fixed swap or a capped rate, and ensure the warehouse's EBIT is contracted with at least 60% anchor tenants. If internal accruals are needed for day-to-day working capital, choose Plan A over Plan B.